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Sunday, November 25, 2018

Brief TIPS Market Comment

Chart: 10-Year U.S. Breakeven Inflation Rate

The U.S. inflation-linked bond (TIPS) market is in an interesting position right now. Inflation protection seems cheap, but the question always remains: is it cheap for a reason? Unfortunately, I am not able to answer that question, I am going to just briefly outline the debate.

The chart above shows the 10-year (simple) inflation breakeven, which is calculated by subtracting the quoted yield on a 10-year TIPS (the "real yield") from the conventional 10-year Treasury nominal yield. We can see that the breakeven has dipped below 2%, but it is well above the 2016 lows.

My recently released book (although still waiting on paperback) Breakeven Inflation Analysis offers a comprehensive intermediate level analysis of the properties on breakeven inflation rates.  One of the recurrent themes within the book is the importance of oil prices for breakeven inflation. Most economists normally focus on core measures of inflation (inflation rates excluding food and energy), but the return on TIPS is based on all items (headline) CPI inflation.

Chart: West Texas Intermediate Oil Price
Recent developments in the oil markets help explain the dip in breakeven inflation. Oil prices are certainly not conforming to the usual pattern of firming during an expansion (figure above). This will certainly have a mechanical dampening effect on headline inflation.

Chart: Spot and Forward U.S. breakeven inflation.

We can control for the effects of the drop in oil prices by looking at forward inflation rates. The chart above shows the spot 5-year breakeven inflation rate, and the 5-year rate, 5 years forward. (These two breakeven rates when composed determine the 10-year breakeven inflation rate.) As should be expected, the spot breakeven inflation rate has dipped more the forward rate, since the current fall in oil prices does not imply that oil prices in five years will keep falling. (One could argue that the rule of thumb in commodity markets is that low prices now will help bring higher future prices, due to the reaction on the supply side.)

My usual stance is to be quite cautious with regards to spot breakeven inflation: the market is relatively efficient, and I do not have a strong conviction that I can forecast the short-term path of inflation better than market participants. What is more interesting are forward breakeven inflation rates: these are almost purely a valuation measure. (Unless one subscribes to questionable theories about term premia, in which case one expects the forwards to zoom around based on the inscrutable movements of a term premium.)

We are in the midst of a long expansion, albeit a rather sluggish one. If the U.S. economy can dodge a serious recession, inflationary pressures should eventually be showing up sooner or later. From this perspective, forward inflation rates are not incorporating any form of risk premium against higher inflation. Given the need of an ageing population to hedge inflation risks in retirement, this obviously makes the levels of forward breakeven inflation interesting.

Unfortunately, there is also a simple explanation for the current situation. A number of risk asset markets are under some strain (such as the oil market), and one could argue that the United States is "due for a recession." (I do not put great weight on theories that suggest recessions happen at regular intervals due to "wave dynamics," but it is still a popular theory.) A recession coupled with a slow, weak recovery could easily lead to inflation being well below where the Fed says it wants inflation to be five years from now.

The only way to resolve that debate is to have a stronger view about recession timing. With my breakeven inflation book out of the way, I will be running through the recession risk analysis, which is a topic of a planned upcoming book. From my perspective, the big question is whether I can finish the book before the next recession hits...

Finally, have a good Grey Cup Sunday!

Universal book link for Breakeven Inflation Analysis

(c) Brian Romanchuk 2018

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